The U.S. Airlines industry has gone through several ups and downs in the past five years. Major negative influences on the industry included skyrocketing oil prices since 2005, economic recession in the U.S. since 2008, global economic downturn in 2009 and the “swine flu” outbreak.

The airlines industry is cyclical and sensitive to a number of key drivers, the most prominent of which is the world price of crude oil. Since the beginning of 2009, prices of crude oil have been half of what they had been the year before, creating some relief for airlines. However, some industry operators hedged their fuel contracts at higher rates and are still paying the price.

Many of the top airlines in the industry have responded by reducing services and aircraft fleet sizes, introducing new fees and higher fuel surcharges and reducing the number of people employed. Even with the price of fuel cut by half in 2009, these measures are expected to remain in place during the year. This is mainly due to a sharp decline in demand for travel, which can be as damaging for operators as high costs.

The airlines industry will be spending the next five years playing catch-up after suffering under the recession in 2009. Industry drivers all point to a slow recovery during 2010 and faster growth in the next four years. Additional fees and charges will continue to be the main method to offset oil price volatility. Hedging strategies are another profit protection tool and will be more extensively undertaken than in the past, despite the large drop in oil prices.

The volatility of oil has brought the benefits of successful risk management strategies such as hedging to the forefront of airline executives’ minds. Air fares are expected to increase in 2010 with slightly higher passenger numbers. Confidence on both the consumer and business sides are expected to be up during the year, supporting demand for air travel. Fuel prices will remain subdued in 2010, giving the industry a breather after years of losses.

We also expect an increase in merger and acquisition activity in response to the challenges facing the industry. During 2009, operating conditions will remain tough and some companies will need rescuing from bad debts, large losses or similar items. Low-cost airlines are expected to weather the storm in 2009 with most tailwinds, as consumers will keep turning towards cheaper options. This will put them in a favorable position in 2010 and may make them purchase some smaller regional operators.

OPPORTUNITIES

Though almost all carriers are expected to post negative earnings in 2009, we favor Southwest Airlines (LUV), as it is the most successful low cost carrier in the U.S. Southwest has maintained continued profitability for the last 30 years — even during periods of industry downturns — mainly due to its strong fuel hedging strategies. Low-cost airlines are expected to get a higher share of revenue in the future, which will see structural changes in the industry and consolidation as a result of competitive pressures.

Another carrier, JetBlue Airways Corporation (JBLU), is projected to fare better than the average major player during the 2009 recession due to the competitive nature of the product and an increase in demand for low-cost services. The company has been able to increase its revenues ahead of the industry average for the past four years. Though JetBlue recorded losses in 2008, it is trying to sustain its profitability by downsizing its workforce and canceling routes.

WEAKNESSES

As a means of recovering lost revenues, some airlines have been increasingly using higher fees. Additional charges have focused on forcing passengers to pay more to check in additional baggage, which can cost up to $50 each way. This has led to a lack of pricing transparency in the industry. United Airlines (UAUA), Delta Airlines (DAL) and American Airlines (AMR) are some of the airlines whose reputation has suffered due to this. Moreover, volatility in oil prices in times of falling demand has taken a toll on these air carriers.

Zacks Investment Research